Chapters refer to the prescribed text: Rankin, M, Stanton, P, McGowan, S, Ferlauto, K & Tilling, M 2012, Contemporary issues in

accounting, John Wiley & Sons Australia.

2014

Advanced Accounting

Notes Unit 200267

University of Western Sydney

1

Advanced Accounting

Topic: Introduction to advanced accounting

Chapter 1

What is theory?

Theory helps explain a phenomena, a situation etc. It helps explain an opinion.

Positive theory - Describes - Explains - Predicts - Uses deductive reasoning

Normative theory - Suggests - Recommends - Uses inductive reasoning (this is the

type of reasoning accountants tend to use)

Why do we use theories in accounting?

In accounting we use theories for the following reasons:

1) To explain what is happening in the accounting practice

2) To describe what is happening in the accounting practice

3) To predict what may happen in the accounting practice

4) Recommend or suggest what should happen in the accounting practice

Positive theory explained

Positive research seeks to predict and explain particular phenomena. The associated

theories of positive research are positive accounting theories (PAT). Positive theories are

developed through some form of deductive logical reasoning. Thus, the explanation and

prediction of particular phenomena is assessed based on observation – that is observing

how the theory’s predictions correspond with the observed facts.

Normative theory explained

Normative theories prescribe particular actions. It is based on what the researcher believes

should occur in particular circumstances. As it is not based on observation it cannot be

evaluated on whether they reflect actual accounting practice. They may rather suggest

radical changes in the way things are done.

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Topic: The Conceptual Framework

Chapter 2

What is the Conceptual Framework (CF)?

The CF is a set of guidelines we use as accountants to prepare financial reports. The CF is a

normative theory, which is used to apply theory to practice. It consists of a coherent system

of concepts, which are guidelines to the accounting standards used for financial reporting.

Under paragraph 12 of the CF, talks about “helping users make useful decisions”, this is

known as the decision usefulness theory, which explains how it helps stakeholders make

decisions about organisations.

The CF as normative theory

The CF is a normative theory in that it seeks to guide individuals in selecting the most

appropriate accounting policies for given sets of circumstances. The CF is seen as a

normative theory in that it provides guidance on how assets, liabilities, expenses, income

and equity should be defined recognised and measured.

Difference between CF and Accounting Standards

Conceptual Framework - Designed to provide guidance and

apply to a wide range of decisions - Concerned with General Purpose

Financial Statements (GPFSs)

Accounting Standards - Specific requirements for a particular

area - May go beyond the CF - Are mandatory - Sometimes conflict with the

framework

Note: The CF is used as guidance for setting Accounting standards.

Structure and components of the CF

What is the purpose of financial statements? -Concerned with GPFS - prepare financial information useful to existing and potential investors, lenders and other creditors in making decisions. - FSs should provide information that:

Help predict the future

Provide feedback on previous decisions

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Accountability and stewardship

Who are they prepared for? - Existing and potential investors - Lenders - Other creditors

What assumptions are to be made when preparing financial statements?

- Normally prepared on the assumption that an entity is a going concern and will continue in operation for the foreseeable future

What type of information should be included?

Fundamental qualitative characteristics: - Relevance - Faithful representation

Enhancing qualitative characteristics:

- Comparability - Verifiability - Timeliness - Understandability

What are the elements that make up financial statements?

- Assets - Liabilities - Equity - Income - Expenses

When should the elements of financial statements be included?

The elements should be included if they meet the two criteria below:

- Probability; and - Measurability

Pros and Cons of the CF

Benefits Problems and Criticisms

- Technical benefits:

Basis for setting accounting rules

Helps individuals prepare, audit or use FSs

- Political benefits:

Prevents political interference in setting accounting standards

- Professional benefits:

Protects the professional status of accounting and accountants

- Its ambiguous, principles can be too vague therefore leaving room for alternative interpretations

- Its descriptive not prescriptive - The concept of faithful

representation is inappropriate

Realist view: FSs are representationally faithful as long as they provide and objective picture of an entity’s resources

Social constructionist view: although the world is as it is, we as accountants information and therefore create reality.

True and fair view in accounting

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P 1.1: AASB 101 paragraph 15; tells us that FSs shall present fairly the financial

position performance and cash flow of the entity.

The Australian Corporations Law s297, 295 paragraph 3 part c; talks about faithful

representation

The CF: Qualitative Characteristics; faithful representation

What is the decision usefulness theory and why is it such an important theory?

The CF defines the objective of decision usefulness theory that financial information about

the reporting entity is useful to existing and potential investors, lenders and other creditors

in making decisions about providing resources to the entity.

This is an important theory in that it helps provide information useful to users in making

decisions. The decision usefulness theory helps us to predict what may happen in the future

although financial statements do not necessarily provide information in relation to the

future; they help users make predictions upon these. This theory also helps provide

feedback on previous decisions. Information in financial statements can help decide

whether past decisions were correct and the information used to make those decisions

where appropriate. Thus this helps users to assess whether better decisions can be made in

the future.

Topic: Measurement issues and the theory of decision usefulness

Chapter 4

Supporting evidence: Whittington Article

Why do we measure things?

To provide information for users to make decisions.

What theories link to measurement?

- Decision usefulness theory

- CF as a normative theory

What is measurement issues facing accountants?

There are a number of measurement challenges that accountants face especially when

accounting for social and environmental aspects of accounting. The three key issues

surrounding measurement in a social and environmental perspective:

- What needs to be measured and accounted for?

- How can discretion and subjectivity associated with the estimation of values be

managed?

- What are the consequences associated with accounting for social and environmental

aspects of the entity.

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One of the most significant challenges is coping with measurement in the context of

accounting for green assets and other environmental and sustainability issues. Challenges lie

in the measurement issues and controversy surrounding how intangible assets are

accounted for. Challenge is how to measure and account for water as a limited natural

resource with a view to sustainability.

How can theories help us resolve these dilemmas?

Should our CF and standards allow choices of measurement methods?

How does this choice of measurement methods connect to ideas of decision usefulness?

The measurement methods used to produce accounting information impact on the quality

and thus usefulness of accounting information The decision usefulness theory is of

significance as financial statements produced containing good quality information will

enable users to make appropriate decisions in order to fulfil the decision useful objective.

However, poor quality information could potentially mislead users and lead them to make

inappropriate decisions. This in effect will give the impression that management has not

performed to the best of their abilities and have not managed the resources of the entity

effectively and efficiently. Therefore, it is crucial to provide information using measurement

methods that is both beneficial to users and accurately depicts the performance of

management.

How do we measure patents (i.e. intangible assets)?

Cost approach is the best valuation technique for patents. Intangible assets use estimation

valuations to measure them.

Topic: Measurement: The Fair Value debate

Chapter 10

Supporting evidence: L & L article 2009

Fair value vs historical cost

Main two types of measurement:

Fair value Historical cost

Advantage - Relevant (as it based on present

value)

Advantage - Comparable - Reliable (since asset price cannot be

changed)

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Disadvantage - Problems with reliability: as the

market changes - Involves subjectivity in tier 2 and 3 - Tier 1 does not always work because

of inefficient markets

Disadvantage - Problems with relevance

3 tiers of Fair value

Tier 1 Active market: use active market price

Tier 2 Adjust: if no active market then look at a similar assets to set price

Tier 3 Estimate: use calculator to put a value to that asset e.g. intangibles, biological assets etc.

Why is the fair value debate so important?

The fair value debate has become important as a result of the GFC. Standard setting has

moved increasingly towards the use of fair value. Current accounting standards allow a

range of measures – mixed measurement system and this is likely to change. It is important

to be aware of the strengths and weaknesses of fair value accounting (FVA) as the increased

adoption of FVA is likely to affect the future careers of accountants.

Arguments for and against fair value

FOR AGAINST

- Faithful representation – quoted market price set by forces outside the entity for tier 1

- Relevant – useful, how much we pay or receive for an item now is relevant to decision to buy or sell…timely

- Understandable – easy concept to grasp, amount to be received if item was sold. What the item is worth from a market perspective. However, not so easy for tier 2 and 3

- Comparable between entities, determined at the same point in time

- Ignores the going concern assumption – measures values as though the entity was intending to sell off all assets and liquidate

- value depends on circumstances e.g. current market conditions

- specialised assets – not bought and sold on an active market, unique with no value other to entities

- measured at current date – influenced by short term

- subjective – for items with no active market, we form an estimate of fair value

- market prices – represent expectations, expectations based on predictions, predictions may not be correct = volatility in market prices caused by market corrections

Fair value valuation techniques

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Market approach: based on the ability to identify a market for an identical or comparable

asset or liability.

Income approach: based on converting future cash flows or income and expense into a

single present value.

Cost approach: based on an estimate of the cost of replacing the ‘service capacity’ of the

asset under consideration. Known as the current replacement cost in accounting theory.

What is information asymmetry?

This is where managers possess more information about current and future prospects of an

entity than people external to the entity for example investors. Therefore, since managers

can choose when and how to communicate this information, this creates volatility in the

market.

PAT theory suggests that managers who have possession of this information, are given the

incentive to disclose this information in the form of good or bad news to the market, which

further supports the volatility of the market and impacts upon the decisions of external

stakeholders to entity in that it directly affects market speculations.

8

Topic: Positive Accounting theory, Signalling theory and Earnings Management

Chapters: 5,6 and 8

Supporting evidence: Gaffikin 2007

Positive Accounting Theory (PAT)

- Based on the works of Watts and Zimmerman. It seeks to explain and predict why

managers choose certain accounting methods over others. (Rankin 2012, pg. 134). PAT is

derived from the agency theory and contracting theory.

Central to PAT is the acceptance of the rational economic person assumption, which

assumes that an accountant is primarily motivated by self-interest, which is premised on the

fact that the accountant is rewarded in terms of accounting based bonuses.

PAT has three hypotheses developed under the Agency theory:

Hypotheses Description

Bonus plan Aims to look better in front of investors. Manager in a firm with a bonus plan tied to report net income at higher levels therefore, this is achieved by choosing accounting methods that bring earnings forward (i.e. earlier recognition of gains)

Debt covenant Firms with a higher debt equity ratio (i.e. firm more reliant on debt), the manager is likely to choose accounting methods that increase net income where the firm is less likely to breach debt covenants.

Political cost Larger firms are associated with more political scrutiny, therefore; too much net income results in more government interference and regulation. So management adopts accounting policies that reduce reported net income.

Perspectives of PAT

Efficiency perspective Opportunistic perspective

Choosing accounting methods that best reflect underlying economic use.

Every manager is for himself or herself and acts in self interest and opportunistic behaviour.

Contracting theory: theory that organisations are characterised as a ‘legal nexus of

contracts’, with contracting parties having rights and responsibilities under these contracts

(Rankin 2012, pg. 135). Contracting is designed to reduce monitoring and bonding costs and

to reduce the resulting residual loss.

Agency theory: theory concerning the relationship between a principal and an agent of the

principal. Agency theory concentrates on two agency relationships: the relationships

between owners as principals and managers as their agents; and the contractual

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relationship between lenders as principals and managers acting on behalf of owners as

agents (Rankin 2012, pg. 135).

PAT criticisms normative theories

Since normative theory is not based on observation (under PAT observation based research

is deemed to be scientific research which is considered akin to ‘good’ research) but rather

on personal opinion about what should happen. In contrast, PAT theorists argue that they

do not impose their view on others; they merely provide information about the expected

implications or particular actions and let individuals decide for themselves as to what they

should do.

Normative theory criticisms of PAT

As PAT does not provide prescriptions, this decision could alienate accountants from their

counterparts in the profession, as a lack of prescription implies a conservative bias.

Normative theory also argues that PAT is value free, as it stresses that all human action is

driven by self-interest. This assumption is regarded as far too negative and simplistic

perspective of human actions, as researchers preferences and expected payoffs affect the

choice of topics, methods and choices of individuals. In this sense all research including

positive research is value laden.

Criticisms of PAT

- Only describes what is already happening. Doesn't suggest ways to improve

accounting practice to help in the real world.

- Cannot say that all individuals act in self-interest when there are various codes of

ethic and conduct accountants must follow and adhere to as members of

professional accounting bodies.

- Firms make more than one accounting policy choice throughout the financial year,

therefore it’s not possible to a research only one policy choice as different policy

choices offset each other creating a portfolio effect.

- By focusing on one goal or accounting policy choice at a time, you miss out on

interactions between goals and trade offs

Signalling theory

Signalling theory suggests that reporting entities can increase their value through financial

reporting. So when organisations disclose information about themselves to the public

because they want to tell something important. This theory provides that manager’s choices

reveal private information, making private information public. To be a signal there must be a

choice as choices signal credible information about expectations and the entity. The

diversity of reporting practices facilitates this role of reporting as a signal. Earnings

management (EM) can acts a vehicle for the release of inside information and act as a signal.

This characteristic of signalling theory gives entities the motivation to show that they are

better than non-reporting entities through the disclosure of financial statements. Thus, this

10

theory is a self-regulating system, in which every entity has a reason to issue financial

statements to lower its cost of capital.

Earnings Management

Earnings management (EM) is the use of accounting discretion through choice of accounting

policy, with a specific objective regarding the level of reported earnings (i.e. to achieve a

desired level of earnings in a particular reporting period). EM takes advantage of timing

differences and brings revenue into year where it is needed and postpones expenses to

subsequent years.

EM comes with information asymmetry. It is an accounting tool. Within the law EM is

referred to as income smoothing and creative accounting. Outside the law it can constitute

fraud.

EM is linked to the decision usefulness theory in light of the opportunistic and efficiency

perspectives of EM. See supporting evidence from Signalling theory paper.

Good and Bad Earnings management

Good EM Bad EM

- Provides choice of accounting policy - Actions affect earnings - Communicates inside information

which acts as a vehicle to signal the market

- Smooths earnings- ensure future stability of the firm/political outcomes

- Efficient contracting- level of manager effort is depicted

- Credibility – market knows managers would be foolish to report higher earnings that cannot be sustained

- Confuses or does not disclose - Less decision useful info, earnings

power overstated - Encourages shirking and increases

asymmetry - Affects actions in real world and long

term objective - Opportunistic manager behaviour - Debt covenant constraints - Maximisation proceeds on share

issue - Motivations to manage earnings

Fraud and EM

- EM could lead managers to provide incorrect information on financial statements. Could

lead to the intentional misstatement or omission for example WorldCom – capitalisation vs

expenditure and Enron – inadequate disclosure obligations. There could also be intent to

deceive or mislead which as a result could lead to illegal actions to manipulate financial

statements to cover up illegal acts – embezzlement.

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Topic: Accounting regulation and standard setting

Chapter 3

What is regulation?

Regulation is the policing, according to a rule, of a subject’s choice of activity, by an entity

not directly party to or involved in the activity (Rankin 2012, pg. 70).

Elements of regulation:

- Intention to intervene

- Restriction on choice to achieve certain goals

- Exercise of control by a party independent of those directly involved in the activity.

The elements of regulation explain the objective of regulation and why regulation is needed.

Why is there a need for regulation?

The above elements of regulation are the prime reasons why regulation is needed.

Some form of regulation is necessary, as markets do not always operate effectively and in

the interests of society. Thus it can be said that the need for regulation arises from the

ideology of efficient markets and the need to maintain a competitive market environment in

order to avoid bureaucratic control in the form of monopolies (Gaffikin 2005, p4-5).

The need for regulation also arises due to information asymmetry, in that accounting

standards are created to address the problem of information inadequacies, which relates to

decision usefulness theory (Gaffikin 2005, pg 5).

Regulation is also necessary in the rationalisation and coordination of economic activity, so

as to organise behaviour or industries in an efficient manner. This also creates information

useful to users when making decisions.

Theories that support why regulation is needed

With regulation comes decision usefulness. Therefore, if we had no regulation then

accounting information wouldn't be useful.

Public interest theory: accounting information is seen as a public good, in which it assumes

that economic markets are not perfect and regulation is costless (Lecture 6, slide 11).

Under this theory, regulation is seen as achieving publicly desired goals and is provided in

response to the demand from the public to correct inefficient and inequitable markets,

which if left to the market alone would not be achieved (Gaffikin 2005, pg. 8).

As there is a mix of public and private participation in the standard setting process, parties

that have an interest in accounting standards often have conflicting interests, for example

12

external stakeholders may prefer flexibility whereas external shareholders may prefer

comparability. On the other hand auditor may prefer objective reporting.

Private interest group theory: regulation is a product of lobbying. There is the assumption

that there are powerful groups in the accounting profession which influence how

accounting information is produced. Therefore we need regulation to minimise the risk of

such professional bodies from abusing their power while lobbying.

Under this theory, powerful groups affected by accounting standards have an incentive to

lobby standard setters to achieve favourable outcomes in their interests.

Many different lobby groups include:

- Industry and management; who are highly motivated and resourced

- Casual non-professional users: those who have disparate interests and few resources

- Full time professional users: secretive and non responsive

- Auditors: accused of self interest

- Academics:

Examples of lobby groups in Australia:

- G100

- Large accounting firms (ego Big Four)

- Professional accounting bodies (egg CPA, ICA)

- ASX

- Major banks (e.g. Westpac)

Capture theory: based on the assumption that powerful groups capture how regulation

works and use it for their self-interest. This theory assumes that self-interested groups aim

to maximise the incomes or interests of their members. This assumption is supported by the

idea that coercive government power can be used to give valuable benefits to particular

groups and that regulation can be viewed as a product that is governed by the laws of

supple and demand (Lecture 6, slide 12)

Bushfire theory: when there is a crisis in the market, standard setters step in to create new

standards or change standards to control the situation.

This theory highlights the political and public nature of regulatory influences by attempting

to take into account the reactions of users and society, to failures of regulatory processes

(Lecture 6, slide 13).

Refer to the GFC.

Theory that supports why there is no need for regulation

Signalling theory: suggests that reporting entities can increase their wealth through

financial reporting, which is affected by the information asymmetry of managers. Therefore,

firms face a competitive capital market populated by sophisticated investors. Above-average

13

entities are motivated to show that they are better performers than non-reporting entities.

Therefore, non-reporting entities are perceived as poorer quality then before (Lecture 6,

slide 10). This ultimately creates a virtues cycle where regulation is not necessary, as non-

reporting entities will produce information available to investors in order to stay

competitive. Therefore under the signalling regulation is not needed, as information supple

would still exist without regulation.

Advantages of regulation

- increased efficiency in allocating capital

- Cheaper production

- Check on prerequisites

- Public confidence

- Standardisation

- Public Good

Disadvantages of regulation

- Difficult to achieve efficiency and equity

- Determining the optimal quantity of information is problematic

- Regulation is difficult to reverse

- Communication is restricted

- Reporting entities are different

- There is lobbying

- Monopolisation of accounting standards

Rule based standards vs Principle based standards

Rule based standards: sets of detailed rules that must be followed when preparing financial

statements.

Disadvantages of rule based

- Can be very complex and stringent

- Organisations can structure transactions to circumvent unfavourable reporting

- Standards are likely to be incomplete or even obsolete by the time they are issued

- Manipulated compliance with rules makes auditing more difficult

Principle based standards: based on the CF that provides a broad basis for accountants to

follow. The focus is essentially on the economic substance of transaction, engaging the

professional judgment and expertise of those preparing financial statements.

Advantages of principle based

- They are simpler

- They supple broad guidelines that can be applied to many situations

14

- They improve faithful representation of financial statements

- They allow accountants to use professional judgment

- Evidence suggests that managers are less likely to attempt earnings management

Disadvantages of principle based

- Managers may select treatments that do not reflect the underlying economic

substance

- The judgment and choice involved in many of the decisions mean that comparability

among financial statements may be reduced.

Topic: Systems oriented theories:

Political economy

Legitimacy

Stakeholder

Institutional Chapter 5

Systems oriented theories help understand the behaviour and reporting of management,

specifically when it comes to sustainability reporting.

Political economic theory: accepts that society, politics, and economics are inseparable so that issues, such as economic issues, cannot be considered in isolation from social and environmental issues (Deegan & Blomquist 2006, p.8)

The perspective embraced is that society, politics and economies are inseparable, and

economic issues cannot meaningly be investigated in the absence of considerations about

the political, social and institutional framework in which the economic activity takes place.

Gurthrie and Parket (1990) states that corporate reports cannot be considered as neutral,

unbiased documents …., but rather are ‘a product of interchange between the corporation

and its environment and attempt to mediate and accommodate a variety of sectional

interests.’

Two Broad streams which Gray, Owen and Adams have labelled are:

Classical political economy Bourgeois political economy

– Karl Mars explicitly places “sectional (class) interests, structural conflict, inequity, and the role of the State at the heart of the analysis. Classical political economy tends to perceive accounting reports and disclosure as a means of maintaining the favoured positon of those who control scarce

– Gray, Kouhy and Lavers largely ignores these elements and, as a result, is content to perceive the world as essentially pluralistic. Bourgeois political economy does not explicitly consider structural conflicts and class struggles but rather ‘tends to be concerned with interaction between groups in an essentially pluralistic world.

15

resources (captial), and as a means of undermining the position of those without scarce capital. “It focuses on the structural conflicts within society”.

Stakeholder theory and legitimacy theory are grounded in the ‘bourgeois branch’ of political economy theory (Gray, Owen and Adams. 1996).

Legitimacy theory

Is based on the idea of social contract and links to the idea of influencing the perceptions of

stakeholders (Rankin 2012, p.124). Legitimacy Theory relies upon the notion that there is a

‘social contract’ between the organization in question and the society in which in operates.

The ‘Social contract’ is the concept used to represent the multitude of implicit and explicit

expectation that society has about how the organisation should conduct its operations.

A corporate entity wants to be seen as a legitimate corporate citizen; however this is not

always the case as legitimacy would be threatened.

Legitimacy Theory asserts that organizations continually seek to ensure that they operate

within the bounds and norms of their respective societies, that is, they attempt to ensure

that their activities are perceived by outside parties as being “legitimate”.

These bounds and norms are not considered to be fixed, but rather, change over time,

thereby requiring the organization to be responsive to the environment in which they

operate.

It is assumed that society allows the organisations to continue operations to the extent that

it generally meets their expectation. Legitimacy Theory emphasises that the organization

must appear to consider the rights of the public at large, not merely those of its investors.

Failure to comply with societal expectations may lead to sanctions being imposed by

society. For example, in the forms of legal restrictions imposed on its operation, and

reduced demand for its products.

Lindblom 1994 identifies four courses of action that an organisation can take to obtain or

maintain legitimacy as follows:

1. Seek to educate and inform its ‘relevant publics’ about changes in the organisations performance and activities;

2. Seek to change the perception of the “relevant publics”; 3. Seek to manipulate perception by deflecting attention from the issue of concern to

other related issues through an appeal to emotive symbols or; 4. Seek to change external expectation of its performance.

16

Stakeholder theory

There are two branches of stakeholder theory, namely:

- Ethical (moral) or normative branch and; - Positive (managerial) branch.

Managerial perspective (positive theory) Ethical perspective (normative theory)

- Meet the information needs of powerful groups e.g. government, banks, professional bodies and employees etc.

The managerial branch of stakeholder theory perspectives attempt to explain when corporate management will be likely to attend to the expectations of particular (powerful) stakeholders. According to Gray, Owen and Adam, this perspective tends to be more ‘organization centred’. Within the stakeholder theory, the organisation is also considered to be part of the wider social system, but this perspective theory specifically considers the different stakeholder groups within society and how they should best be managed if the organisation is to survive. Freeman (1984) discusses the dynamics of stakeholder influence on corporate decisions. A major role of corporate management is to assess the importance of meeting shareholder demands in order to achieve the strategic objectives of the firm. According to Evan and Freeman (1988), the very purpose of the firm is, in our view, to serve as a vehicle for coordinating stakeholders. It is through the firm that each stakeholder group makes itself better off through voluntary exchanges. Within the managerial perspective of Stakeholder Theory, information is a major element that can be employed by the organization to manage (or manipulate) the stakeholder in order to gain their support and approval, or to distract their opposition and disapproval. This is consistent with the

- Meet the information needs of a wide range of groups despite power e.g. local community, minority groups, customers, environmental groups and individual activists etc.

The moral (and normative) perspective of Stakeholder Theory argues that all stakeholders have the right to be treated fairly by an organization, and that issues of stakeholder power are not directly relevant. Clarkson (1995) sought to divide stakeholders into primary and secondary stakeholders. A primary stakeholder was defined as ‘one without whose continuing participation the corporation cannot survive as a going concern’. Secondary stakeholders were defined as ‘ those who influence or affect, or are influenced or affected by, the corporation, but they are not engaged in transactions with the corporation and are not essential for its survival. In considering the notion of rights to information, we can briefly consider Gray, Owen and Adam’s perspective of accountability as used within their accountability model. Gray, Owen and Adam defined accountability as: The duty to provide an account (by no means necessarily a financial account) or reckoning of those actions for which one is held responsible. It would involve two responsibilities or duties: 1 The responsibility to undertake certain

actions; and

17

strategies suggested by Lindblom (1994).

2 The responsibility to provide an account of those actions.

-

Institutional Theory

It considers how rules, norms and routines become established as authoritative

guidelines, and considers how these elements are created, adopted and adapted

over time. Practices within organisations can be predicted from perceptions of

legitimate behaviour derived from cultural values, industry tradition, entity value

etc. (Lecture 7, slide 4).

Institutional theory attends to the deeper and more resilient aspects of social

structure. It considers the processes by which structures, including schemas; rules,

norms, and routines, become established as authoritative guidelines for social

behaviour. It inquires into how these elements are created, diffused, adopted, and

adapted over space and time; and how they fall into decline and disuse (Scott 2004,

p.2).

This theory focuses on the environmental factors experienced by an organization

such as “external or societal norms, rules, and requirements that organizations must

conform to, in order to receive legitimacy and support”. The institutional theory

depends, heavily, on the social constructs to help define the structure and processes

of an organization.

Topic: Reporting issues:

Intangible assets

Heritage assets

Capitalisation

Chapter 14

Background Accounting standards limit the reporting of many items that might otherwise be considered assets or liabilities. This can create a significant difference between a company’s book and market value. There is ongoing tension between the reporting of relevant and reliable information. Some people have suggested that the general problem of incomplete information shows that more information is better even if it is uncertain where relevance is key. However, accounting regulators are increasingly moving to prevent entities measuring and reporting internally generated intangible assets in which faithful representation is a key consideration. (Lecture 8, slide 4).

Accounting for intangible assets

18

Accounting Standard AASB 138 Intangible Assets (that incorporates IAS 38 Intangible Assets) sets out the accounting requirements for intangible assets, including internally generated intangible assets. It requires that all research costs be expensed, while development costs are capitalised if they meet certain specified criteria. Internally generated brands, mastheads, publishing titles, customer lists and items similar in substance are not recognised. This contrasts with accounting for intangible assets that are acquired in a business combination Topic: Critical perspectives/accounting in society. Reading: Reading 8 Deegan (2009).

Tutorial topic: What is critical theory? What are the wider implications of our choices as accountants and regulators of accounting on society as a whole? Are the philosophical underpinnings of accounting and accountants important? Key theories: Everything we’ve studied this semester plus critical theory.

“…in communicating reality, accountants simultaneously construct it”.

“Accounting is a social practice within political struggles and not merely a market practice

guided by equilibrium and an efficient market” (Ruth Hines, 1988)

What is critical theory?

Critical theory was first defined by Max Horkheimer as a social theory oriented toward

critiquing and changing society as a whole.

Critical theory acknowledges the role of power and political connection with accounting.

Gaffikin states that political systems in countries such as Australia are premised on a

capitalist order, in which accountants have been providing information to facilitate optimal

economic decision making in serving the interests of the providers of capital. Critical

theories challenge the assumptions inherent in capitalism since accounting's subservient

relationship to capitalism poses problems for accounting from a critical perspective.

Cooper and Hopper [1990] articulate that "critical accounting is critical of conventional

accounting theory and practice and, through critical social science theory, it seeks to explain

how the current state of accounting has come about". Critical accounting researchers that

an understanding of the significance of accounting and its development requires an

examination of its social context and development of theory needs to be considered open

and refutable (Gaffikin & Lodh 1991).

19

Reading Article Summaries

Stakeholder Influence on Corporate Reporting: An Exploration of the

Interaction Between the World Wide Fund for Nature and the Australian Minerals Industry

by Craig Deegan and Christopher Blomquist

Introduction Two theoretical perspectives that have been used to explain corporate social and environmental reporting practice are stakeholder theory and legitimacy theory. Both stakeholder theory and legitimacy theory are derived from the broader political economy theory (Gray, Owen and Adams, 1996, p.48). Political economy theory, legitimacy theory and stakeholder theory may essentially be seen as broadly similar, as they are concerned with, the power of society to pressurise organisations into disclosure and the desire and ability of the organisation to use information (and particularly social and environmental accountability) to legitimate, to deflect criticism, and to control the debate being held in the wider community (Gray, Owen and Adams 1996, p.48). Legitimacy theory Legitimacy theory posits that organisations continually seek to ensure that they operate within the bounds and norms of their respective societies, that is, that they attempt to ensure that their activities are perceived by outside parties as being ‘legitimate’. Legitimacy theory relies upon the notion that there is a ‘social contract’ between the organisations in question, and the society in which it operates (Deegan & Blomquist 2006, p.9). The ‘social contract’ concept is used to represent the multitude of implicit and explicit expectations that society has about how the organisation should conduct its operations (Donaldson, 1982). This perspective assumes that society allows the organisation to continue operations to the extent that it generally meets their expectations. Legitimacy theory emphasises that the organisation must appear to consider the rights of the public at large, not merely those of its investors. Failure to comply with societal expectations (that is, failure to comply with the terms of the ‘social contract’) are theoretically linked to sanctions being imposed by society, for example, in the form of legal restrictions imposed on its operations, limitations on resources (for example, financial capital and labour) being provided, and reduced demand for its products (Deegan & Blomquist 2006, p.9). Given the potential costs (sanctions) associated with conducting operations that are deemed to be outside the terms of the “social contract”, Dowling and Pfeffer (1975) state that organisations will take various actions to ensure their operations are perceived to be legitimate. One central action is public disclosure of information (referred to as the process of ‘communication’). As community expectations change, organisations must adapt and change, and importantly, such changes must be communicated.

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Stakeholder theory Within the managerial branch of stakeholder theory the organisation is considered to be part of the wider social system (as in legitimacy theory), but this perspective of stakeholder theory specifically considers the different stakeholder groups within society and how they should best be managed if the organisation is to survive (hence we call it a managerial perspective of stakeholder theory) (Deegan & Blomquist 2006, p.12). Like legitimacy theory, it is considered that the expectations of the various stakeholder groups will impact the operating and disclosure policies of the organisation. The organisation will not respond to all stakeholders equally (from a practical perspective, they probably cannot), but rather, will respond to those that are deemed to be ‘powerful’ where the most powerful stakeholders will be attended to first. (Deegan & Blomquist 2006, p.12) A stakeholder’s power to influence corporate management is viewed as a function of the stakeholder’s degree of control over resources required by the organisation (Ullmann, 1985). The more critical the stakeholder resources are to the continued viability and success of the organisation, the greater the expectation that stakeholder demands will be addressed. A successful organisation is considered to be one that satisfies the demands (sometimes conflicting) of the various powerful stakeholder groups (Deegan & Blomquist 2006, p.12).

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Gaffikin Article 2007

Gaffikin, M, 2007, ‘Accounting research and theory: the age of neo-empiricism’, The

Australasian Accounting Business & Finance Journal, February 2007, vol. 1, no. 1, pp. 1-19.

Rational choice theory is fundamental to PAT, in that that is material self-interest is the basis

of all economic activity, which is also termed opportunistic behaviour. Thus self-interest is

suggested to be the reason for the choice of accounting methods, techniques and policy

decisions.

In PAT the firm is described in terms of a collection of contracts, which is explained by

contracting theory. This is where contracts are necessary in order to get self-interested

individuals to agree to cooperate within a firm, and get individual parties to act to maximise

the wealth of shareholders. Thus, PAT holds that firms will seek to minimise the contracting

costs and this will affect the policies adopted, including the accounting policies

There are three hypotheses around which PAT's predictions are organised, viz, the bonus

plan hypothesis, the debt covenant hypothesis and the political cost hypothesis.

Bonus plan hypothesis (page 9)

The bonus plan hypothesis suggests that managers of firms will be more likely to choose accounting procedures that shift reported earnings from future periods to the current period. To understand the need for this hypothesis it is necessary to note that one of the theories underlying positive accounting research is agency theory.

Agency Theory (page 9)

Agency theory extends traditional information economics by recognising that several forces

are at play in organisations that affect how it operates. For example, the notion of

information asymmetry is a problem that impacts on resource allocation issues. There is

information asymmetry when managers have greater information than investors. Agency

theorists believe there has to be incentives for managers to make additional voluntary

disclosures.

According to PAT both parties will act in their own self-interest which will not necessarily

coincide. The classic example of this sort of agency relationship is that between the

shareholders and the managers of a company. Shareholders will be interested in maximising

their wealth; the manager will want to maximise his or her rewards from managing the firm.

Debt covenant (page 10)

The debt covenant hypothesis in PAT is that, other things being equal, the closer a firm is to violating an accounting-based debt covenant, the more likely the owner-manager is to

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select accounting procedures that shift reported income from a future period to the present period. Any increase in current reported income would reduce the likelihood of a technical covenant default. Remember, however, that PAT assumes opportunistic behaviour, so covenants will usually include the basis on which such measures are made because often there are slight variations in how certain accounting measures are derived.

A complicating factor in the debt covenant hypothesis relates to who the managers are. If there is a separation of ownership and management then there is an extra agency relationship to be considered. Consequently, in research to test the hypothesis the case of the owner-manager has often been assumed so as to make it easier to understand why opportunistic behaviour occurs.

Political cost hypothesis (page 10-11)

The third PAT hypothesis is the political cost hypothesis. This suggest that, other things being equal, the greater the political costs faced by a firm, the more likely the mangers will choose accounting procedures that defer reported income from current to future periods. This hypothesis introduces the idea of political implications into accounting policy choice.

This hypothesis of PAT draws attention to the fact that not all policy decisions (including accounting) adopted by a firm will be based on purely economic considerations. When banks announce record profits there will be public pressure on the government to examine their customer charges. Petrol prices are very susceptible to public attention and in 2004 and 2005 the companies that were the leading profit companies (in countries around the world) were oil companies. It lead in some countries to special taxes being imposed on petroleum companies who then (in countries where it was legal, such as the USA) switched to LIFO inventory valuations, which would lead in turn to lower recorded profits and, therefore, lower taxes. Many firms because of their sheer size attract political attention from a variety of "public watchdogs".

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Laux & Leuz 2009

Laux, C & Leuz, C 2009, 'The crisis of fair-value accounting: making sense of the recent

debate', Accounting, Organisations & Society, vol. 34, no. 6-7, pp. 826-834.

Purpose:

- Discusses the potential impact FVA had on the GFC. - Four important issues are highlighted in the article: 1) Controversy about the use of FVA is a result of confusion about what is new and

different about FVA. 2) Concerns about FVA affecting the GFC. And the problems that apply to FVA as set

out by accounting standards 3) Historical cost accounting (HCA) is unlikely to be the remedy. 4) Implementation issues with FVA in practice

Issue 1: FVA what is it and what are the key arguments (pg 827)

- Fair value is defined under IFRS as the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties, in an arm’s length transaction.

- Arguments for FVA: FV for assets or liabilities reflect current market conditions and provide timely information, which increases transparency and encourages prompt corrective actions (Laux & Leuz 2009, pg 827).

- Arguments against FVA: Controversy is in relation to whether FVA is helpful in providing transparency and whether it leads to undesirable actions especially on part of banks and firms. There is a claim that FV is not relevant and potentially misleading for assets that are held for long periods and that prices could be distorted by market inefficiencies, irrationality of investors and that FVs based on models (ie level 3 of the FV hierarchy are not reliable).

Issue 2: FVA and its affect on the GFC (pg 829)

- The primary concern about FVA in the business cycle is procyclical, in that it worsens

swings in the market, and may cause a downturn in financial markets.

- FVA can provoke contagion in financial markets, especially in its pure form by marking to

market prices under any circumstances.

- According to Laux and Leuz (2009) the fair value debate should not be polarised. They

suggest that FVA is neither responsible for the financial crisis nor entirely innocent.

Furthermore, arguments against fair value do not automatically translate into arguments for

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historical cost accounting. The L&L article further suggests that the polarisation in the

debate is founded primarily on different views about the goals of accounting.

Issue 3: Using HCA as a remedy for FVA (page 828)

- Historical costs do not reflect the current fundamental value of an asset. - HCA could come at the price of delaying and increasing underlying problems such as

excessive sublime lending by banks. - Not only should the costs of FVA be considered but the costs of alternatives and the

incentives available to use HCA over FVA during normal or boom times.

Issue 4: Implementation issues with FVA in practice (pg 830 – 831)

- There is a trade-off between relevance and reliability, therefore it is difficult to set FVA standards that provide flexibility to managers when needed and constrain their behaviour when it is not needed.

- Restrictive standards or even some contagion effects are the price for timely write-offs when assets are impaired. Again, this is a trade-off that is important to recognize and difficult to escape in practice242424.

- Implementation problems arise from litigation risk. As deviations from market prices under existing FVA standards require substantial judgment by the financial report preparers however, managers and directors face severe litigation risks. In this environment financial report preparer are likely to weigh the personal costs and risks associated with deviations from market prices differently than investors.

Conclusion (pg 833)

- FVA introduces volatility in the financial statement in ‘‘normal times” (when prompt action is not needed).

- - Second, full FVA can give rise to contagion effects in times of crisis, which need to be addressed – be it in the accounting system or with prudential regulation.

Analysis suggests that implementation problems and, in particular, litigation risks could have

played a role for the performance of FVA standards and banks’ reporting practices in the

crisis.

Finally, it is important to recognize that accounting rules and changes in them are shaped by

political processes (like any other regulation). The role of the political forces further

complicates the analysis. For instance, it is possible that changing the accounting rules in a

crisis as a result of political pressures leads to worse outcomes than sticking to a particular

regime (e.g., Brunnermeier et al., 2009). In this regard, the intense lobbying and political

interference with the standard setting process during the current crisis provide a fertile

ground for further study.

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Whittington Article 2010

Whittington, G 2010, 'Measurement in financial reporting', ABACUS, vol. 46, no. 1, pp.

104-110.

Purpose:

- Identify the single measurement basis that best conforms to relevance and faithful representation.

- Discuss arguments for and against a single measurement basis. - Problems with a single measurement basis due to market imperfection. - Discuss arguments for and against a mixed measurement approach.

Single measurement basis

For (page 105)

- Use of a single method approach would promote consistency and avoid mismatches within accounts.

- This approach will also promote comparability across entities. However comparability will only be useful of the accounting information being compared is relevant to the user.

- When considering fair value as single measurement basis, standard setters have claimed that the fair value method does have relevance properties in that it measures the market’s expectations of future cash flows. And in doing this objectivity was achieved in the sense that the fair value measurement basis reflects the market’s view rather than the entity specific views of managers.

Against (page 105-106)

- In reality the market is imperfect that is markets are not complete and in perfectly competitive equilibrium, therefore, a single measurement method will not always be relevant and reliable.

- Information asymmetry is a barrier to market perfection, as information is not available making it costly and prices cannot perfectly reflect the information available.

- In a setting of market imperfection, accounts provide useful information for decision-making; this means that it is more useful to adopt the objective of identifying the information that is most likely to serve the needs of users when making decisions. This will help provide information to users in their decision making process.

- Ideally in reality a single measurement would be difficult because there are different assets requiring different measurement approaches, which creates an imperfect market in reality. Thus if a single measurement method was used then users cannot make useful decisions.

Mixed Measurement approach (page 107 -108)

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- Mixed measurement approach allows decision usefulness, as different assets will be treated in a different way, therefore different measures for different purposes are appropriate in accounting.

- The objective of a mixed measurement approach allows different measurement methods to be utilised in different circumstances. Thus this method assumes that a pure measure, which uses only one approach, could be associated for example with a particular asset item. However, it recognises that different assets items could be measures by using different methods which best represent the economical properties of the asset item. Therefore the use of a mixed measurement approach provides information that is most relevant to users in assessing the current economic and financial performance and position of the entity they are making decisions about.

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Essay Questions and Answers

Topics:

- Earnings Managements: good or bad?

- Approaches to accounting measurement good or bad?

- For and against regulation

- How does the role of accounting reduce agency problems?

- Systems Oriented theories: What are the implications of using theory to analyse social and environmental disclosures?

Earnings Management

Question 1: Is earnings management good or bad? Discuss. Justify your response through

making connections to relevant theory.

Question 2: What do we mean by the term good EM? Good EM can add value to accounting

information produced. Discuss.

Introduction

Earnings management (EM) is the use of accounting discretion through choice of accounting

policy, with a specific objective regarding the level of reported earnings (i.e. to achieve a

desired level of earnings in a particular reporting period). EM takes advantage of timing

differences and brings revenue into year where it is needed and postpones expenses to

subsequent years. EM comes with information asymmetry. It is an accounting tool. Within

the law EM is referred to as income smoothing and creative accounting. Outside the law it

can constitute fraud.

This definition indicates that EM gives rise to two perspectives, i.e. whether it is good or

bad. The first perspective is that EM can attempt to potentially manipulate the financial

statements through the process of accounting policies manipulation to report earnings in a

more favourable way. The second perspective is that EM attempts to control earnings by

changing actual transaction details or the timing of transactions related to earnings

achieved in a particular period.

1) Good EM

- Theory behind good EM

- Signalling theory (Scott 2009): The main theory in support of the good side of EM is

signalling theory in that EM can act in a way that helps communicate information to

external users. Under the signalling theory managers are able to communicate the

financial health of the organisation, this process of communication involves earnings

management to be used to inform outsiders of the inside information management

by exercising their expertise and professional judgement, EM acts ‘as a vehicle for

inside information’ (Scott 2009) which acts a signal. Signalling theory suggests that

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reporting entities can increase their value through financial reporting. So when

organisations disclose information about themselves to the public because they

want to tell something important. This theory provides that manager’s choices reveal

private information, making private information public. To be a signal there must be

a choice as choices signal credible information about expectations and the entity.

The diversity of reporting practices facilitates this role of reporting as a signal.

Earnings management (EM) can acts a vehicle for the release of inside information

and act as a signal. This characteristic of signalling theory gives entities the

motivation to show that they are better than non-reporting entities through the

disclosure of financial statements. Thus, this theory is a self-regulating system, in

which every entity has a reason to issue financial statements to lower its cost of

capital.

- Efficiency perspective: under the efficiency perspective of signalling theory managers

have the freedom and influence to use accounting policies that help estimate certain

items, which may increase the quality of accounting information, and thus be

efficient. Therefore the efficiency perspective can help maximise the value of the

firm whilst at the same time helps users of financial information to make appropriate

and informed decisions.

- Income smoothing: In the context of an efficient market income smoothing has the

potential to improve earnings informativeness, if managers communicate their

assessment of future earnings. A s fluctuations of reported earnings reduce

investors’ confidence in the expected future cash flows of a firm, this can be a

motivating factor for managers to smooth earnings (Tucker & Zarowin 2005, pg 6).

Even in the absence of an incentive, managers may communicate future earnings

under the efficient contracting theory and thus smooth income, which could make a

firm’s earnings more informative about future earnings and cash flows (Tucker &

Zarowin 2005, pg 6). This in return could improve the decision usefulness of

information provided by the firm to external parties.

- Efficient contracting: under efficient contracting EM is considered good in the sense

that contracts are used to bond the agent to the principal, and financial statement

information is often used to monitor the agent’s compliance with these contracts. As

a result agents have incentives to present the financial statements in a way that

ensures the best outcome under the contracts. Therefore, since contracts need to be

considered when making financial reporting decisions, managers will have an

incentive to use EM in way that doesn’t compromise the ability of individuals both

within and outside the organization to make useful decisions and as long as the

option of flexibility on contracts excludes a manager’s self-interested opportunistic

motivations.

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2) Bad EM

- PAT: 3 hypothesis

The main theory underlying the disadvantageous side of EM is based on the works of

Watts and Zimmerman’s positive accounting theory (PAT). PAT seeks to explain and

predict why managers choose certain accounting methods over others. (Rankin 2012,

pg. 134) which is derived from the agency theory and contracting theory. Central to PAT

is the acceptance of the rational economic person assumption, which assumes that an

accountant is primarily motivated by self-interest, which is premised on the fact that the

accountant is rewarded in terms of accounting based bonuses. PAT has three

hypotheses developed under the Agency theory, under which EM can be used adversely.

Under the bonus plan hypothesis, EM can be used in an attempt to look better in front of

investors. Manager’s in a firm with a bonus plan tied their income may report net income at

higher levels, this is achieved by choosing accounting methods that bring earnings forward

(i.e. earlier recognition of gains). Under the debt covenant hypothesis occurs where a firm

has a higher debt equity ratio, in which the manager is likely to choose accounting methods

that increase net income where the firm is less likely to breach debt covenants. The final

hypothesis is political cost, where larger firms use EM as they are associated with more

political scrutiny, therefore; too much net income results in more government interference

and regulation. So management adopts accounting policies that reduce reported net

income.

- Big bath accounting concept can be used as form of bad EM where: A big bath may be

taken, “during the periods of organizational stress or reorganization” or when “a firm

must report a loss” (Scott 2009). As management may adopt accounting policy choices

to reflect the financial performance of the firm to make it look better than what is

actually is. The likelihood of a big bath being taken when a management change occurs

is also high as a firm may seek to use a change of management as an opportunity to

remove factors that may put pressure on future business performance.

- Examples of bad EM- fraud

EM can be bad in the sense that it can reduce the reliability of financial statements if

reported earnings are changed for unclear reasons and without sound justification by

management. EM could lead managers to provide incorrect information on financial

statements. Could lead to the intentional misstatement or omission for example WorldCom

– capitalisation vs expenditure and Enron – inadequate disclosure obligations. There could

also be intent to deceive or mislead which as a result could lead to illegal actions to

manipulate financial statements to cover up illegal acts – embezzlement.

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Conclusion

In essence, EM has both a good side and bad side to it, which ultimately depends on how

management uses accounting policy choices and creative accounting in exercising

professional judgement. EM is primarily good when it is used to truly reflect the economic

position and performance in a way, which conforms to the Conceptual framework’s

enhancing qualitative characteristics of relevance and faithful representation. If EM is used

appropriately without any bad intentions then it can help add value to financial information

about an entity.

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Approaches to Accounting Measurement: Good or Bad?

Question: Is having choice in approaches to accounting measurement good or bad? Discuss.

Provide an example and make connections to relevant theory to justify your response.

Introduction

- CF provides measurement choices - State that there are both good and bad assumptions about accounting measurement

choices

Body

Arguments that support accounting choices are good

- Flexibility: flexibility in choosing accounting measurement approaches for a firm can allow items to be faithfully represented. If items are faithfully represented then they are more decision useful (AASB 101, paragraph 15). Faithful representation in this context requires that transactions and events should be accounted for in a way that represents the true economic substance of the financial information rather than legal form.

- For example intangible assets cannot be measured using fair value in that no functioning market for these types of assets exist (Hitz, 2007, pg 337). Thus, intangible assets will best be measured using estimation valuations. For example the cost approach will be the best valuation technique for patents as no active market exists for this asset, which illustrates the need to have accounting policy choices to make the most appropriate measurement choices.

- Generally accepted accounting principles (GAAP) require that judgment be exercised in

preparing financial statements by financial report preparers. This exercise of professional

judgment provides information to outsiders when information asymmetries are present.

Thus, the use of professional judgment requires managers to be disinterested and objective

in choosing accounting measurement methods (Fields, Lys & Vincent 2001, pg 259). This in

turn suggests that accounting choice is beneficial when making decisions about which

measurement type will assist investors in making appropriate decision about the firm.

- Another benefit of accounting choice is that it is driven by driven by information

asymmetries, which attempts to influence asset prices. The primary focus in this here is to

overcome problems that arise when markets do not perfectly aggregate individually held

information by investors (Fields, Lys & Vincent 2001, pg 262). Therefore, accounting choice

may provide a mechanism by which better-informed managers can communicate

information to less well informed outside parties about the timing, and the risk associated

with future cash flows.

Arguments that support accounting choices are bad

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- Despite the benefits of having choices in accounting measurement methods,

unconstrained accounting choice is likely to impose costs on financial statement users as

financial report preparers are likely to have incentives to convey self-serving information

(Fields, Lys & Vincent 2001, pg 259).

- There is no doubt that the availability of accounting measurement choices reduces the

comparability of financial reports between entities. This is important in that comparability

of financial reports is an enhancing qualitative characteristic under the CF. Therefore, if this

characteristic cannot be achieved by firms when preparing financial reports then this could

potentially compromise the decision usefulness of information in financial reports. As users

of these financial reports will not be able to make informed decisions about a firm, which

can ultimately undermine the objective of the purpose of financial statements of being

decision usefulness.

Choices can also lead to creative accounting utilised by managers. Managers may use

measurement techniques that overstate earnings, which in turn affect the faithful

representation of information and its decision usefulness.

PAT

- Under PAT, it is suggested that managers exploit their accounting discretion to take

advantage of the incentives provided by bonus plans. Based on the bonus plan hypothesis

there is an assumption that manager’s will aim to look better in front of investors, by

choosing accounting methods that bring earnings forward (Gaffikin 2007, pg 9).

- Another assumption of manager’s motivations for accounting choice is that of influencing

third parties. In situations where third parties use financial information, firms may have an

incentive to manage those numbers due to potential affects of their disclosure policies on

third parties (Fields, Lys & Vincent 2001, pg 281). The common hypothesis referred to here

is the political costs under PAT. This suggests that the greater the political costs faced by a

firm, the more likely it is that managers will choose accounting methods that will defer

reported income to future periods (Gaffikin 2007, pg 10-11) primarily for taxation purposes.

Thus, this hypothesis introduces the idea of political implications of third parties and that

not all choices are based purely on economic considerations when making choices about

measurement methods.

This hypothesis has the potential to affect the decision usefulness of accounting information

and impact upon the decisions of those who use the financial information disclosed by

firms.

Conclusion

Since accounting is used for many purposes, in most situations multiple accounting choices

can be chosen solely or jointly to accomplish one or more goals. Therefore, it would be

inappropriate to analyse an accounting goal in isolation of another, as one goal would have

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a comprehensive theory of accounting choice behind it. Depending on the objectives and

motivations of management, choices in accounting measurement methods can be good or

bad. Nevertheless, since the CF provides measurement choices, it can be concluded that

having a choice in approaches to accounting measurement is good, in that different firms

will need to apply different accounting policies in order to best reflect the financial

performance and measurement of the entity, as well as attain the goals of the firm.

Arguments For and Against Regulation

Arguments for regulation

Public interest theory

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Under the public interest theory one argument supporting regulation is that it is in the public

interest. Without regulation, there is the possibility of failure in the free market system the firm is a

monopoly supplier of information about itself. This situation creates the opportunity for restricted

production of information and monopolistic pricing if the market is unregulated. Therefore,

mandatory disclosure would result in more information and a lower cost to society. Better

regulation is necessary to raise the quality of financial reporting in order to protect the public from

fraud and failures.

Relating further to public interest theory is that accounting information is a public good, and public

goods will be under-produced in a free market. Under-production of public goods occurs because

producers are not able to impose production costs on all users of the good, and are not motivated to

meet real demand. Intervention in the form of regulation can increase production as mandatory

requirements of producing accounting information will ensure that the real demand for such

information is adequately met.

Regulation will also reduce information asymmetry. Since free markets are contrary to society’s

goals they may not communicate enough information to the market in the absence of regulation,

resulting in insiders i.e. managers having information that is not available to shareholders. Thus,

regulation of disclosure requirements will help markets become efficient in that accounting

information would be available to outsiders, i.e. external parties to the firm. This in turn will help

external parties make well-informed decision, which would otherwise not be available in

unregulated markets.

Arguments against regulation

The arguments supporting unregulated markets for accounting information are based on agency

theory, signalling theory, and private contracting opportunities.

Agency theory predicts a conflict of interest between owners and managers, where owners are

interested in maximising return on investment and security prices, while managers desire to

maximise their total remuneration. Due to this potential conflict, owners incur costs in monitoring

agency contracts, which in effect reduce managers’ remuneration package. Therefore, financial

reporting is deemed to be a way of mitigating this conflict, and allowing owners to monitor

employment contracts with their managers. Minimising agency costs is an economic incentive for

managers to report accounting results reliably to owners. Good reporting will enhance the

reputation of a manager, and should result in higher remuneration amounts as agency monitoring

costs are minimised if owners perceive that accounting reports are reliable. Thus this help depicts

that accounting information will still be produced in an unregulated market.

Signalling theory explains why firms have an incentive to report voluntarily to the capital market in

the absence of regulation: voluntary disclosure is necessary in order for firms to compete

successfully in the market to maximise its earnings. Since insiders know more about a firm and its

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future prospects than outsiders; investors will protect themselves by offering a lower price for the

firm’s stock price. However, the value of a firm can be increased if the firm voluntarily signals

private information about itself that is credible and reduces outsider uncertainty (Scott 2009).

Based on the assumptions of contracting theory another argument against regulation is the

presumption that anyone who genuinely desired information about a firm would be able to obtain it

by privately contracting for information with the firm itself. The parties to these contracts can

include shareholders, managers, lenders, employees, suppliers and customers (Rankin 2012, pg135).

If information were desired beyond that which is publicly available and free of charge, private

individuals would be able to buy the desired information where market forces should result in the

optimal allocation of resources to the production of information.

Since the goal of the standard setting process should be to provide the best standards from the

societal point of view, it is not possible to derive regulatory policies that will knowingly maximise the

welfare of society. In the absence of a free market pricing system, it is difficult aggregate social

preferences. However, if there is a free market pricing system, aggregate social preferences are

revealed through supply-demand, and resources will be allocated according to market prices.

Therefore, there is no comparable rule in a regulated market, so it is difficult to know if accounting

regulation is producing the optimal quantity and quality of financial information for the benefit of

society.

Role of Accounting and Agency Question: How does the role of accounting reduce agency problems?

Accounting information plays an important role in reducing agency costs, by monitoring and binding

the mechanisms to control the efforts of self-interested agents (Deegan 2006).

The role of accounting plays a central role in both determining the extent of the agency conflicts, and in designing the mechanisms that resolve such conflicts. Specifically, a wide range of agency conflicts are either created or exacerbated by the fact that certain contracting parties possess superior firm-specific information at various times before or during the contracting relationship. Further, even when all contracting parties are equally informed, uncertainty about future events creates demand among contracting parties for information about current and future business conditions. In this paper, we discuss literature related to how financial reporting helps to satisfy capital providers’ contracting demand for information about firm performance and managers’ actions, and thereby mitigates agency conflicts. Debt covenants

Even in the absence of information asymmetry, information uncertainty poses problems in debt

contracting. That is, even when managers and lenders enter into contacts with the same

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information, the incomplete nature of debt contracts creates a demand for mechanisms that

allocate decision rights in the future conditional on the realization of certain events (both foreseen

and unforeseen).

The general conclusion in this literature is that financial reporting is useful because more efficient contracts can be established when contracting parties are able to commit to a more transparent information environment. Another key theme of our review is the notion that a firm’s contractual arrangements and its corporate information environment evolve together over time to resolve agency conflicts. That is, certain contractual arrangements work more efficiently with certain information environments in general and financial reporting choices in particular. As a result, one does not expect to observe firms converging to a single dominant type of corporate governance structure, compensation contract, debt contract, or financial reporting system This survey highlights the important role that the corporate information environment plays in contracts that serve to mitigate governance- and debt-related agency conflicts. With respect to governance, we emphasize research on the role of financial reporting in reducing information asymmetries that exist between managers and both outside directors and shareholders. This asymmetry stems in large part from the fact that managers typically have better firm-specific information than outside directors and shareholders, but cannot always be trusted to report information that is detrimental to their personal interests (e.g., information indicating poor performance, extraction of private benefits, etc.). Boards, which are largely comprised of outside directors and shareholders, therefore, are typically assumed to be at an informational disadvantage when monitoring managers. Indeed, in the absence of information asymmetries, it becomes relatively easy for boards to resolve many (or most) agency conflicts with managers, particularly since boards retain considerable discretion in their monitoring of managers and can therefore take immediate action upon receiving new information. Thus, one potential role for the financial reporting system is to provide outside directors and/or shareholders with relevant and reliable information that aids in the effective monitoring of management and/or directors. Further, to the extent that financial reporting serves as a mechanism to reduce information asymmetries, one expects to observe cross-sectional variation in other governance mechanisms that covaries with financial reporting characteristics.

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Systems Oriented Theories

Question: What are the implications of using theory to analyse social and environmental disclosures? Discuss this question using legitimacy and stakeholder theory in light of real life examples.

Which of the following theories provide insight as to why social and environmental issues and impacts such as carbon emissions and management of water are so important from a reporting perspective?

Explain the connections to relevant theory/theories to justify your response

- Stakeholder theory - Legitimacy theory - Institutional theory - Accountability theory

Introduction

In recent years stakeholders have been increasingly expecting more than just the disclosure

of financial information in relation to the financial position and performance of the entity. A

wide range of stakeholders also requires information about the environmental and social

performance and impacts of an entity. Therefore, reporting entities have increasingly used

their annual reports to voluntarily report information relating to their social actions and in

particular concerning the natural environment (Gray et al 1995). There has been a move by

entities towards a triple bottom line reporting model, which is also known as sustainable

reporting where in addition to economic performance, social and environmental issues of

the entity’s performance are given (Deegan 2002). Thus, there are a number of theories

which have been postulated as to why entity’s disclose such information which are based on

systems oriented theories which focus on the role of information and disclosure in the

relationships with stakeholders and in which the entity is assumed to be influenced by the

society in which it operates and to have an influence on it. The three key theories are

stakeholder theory, legitimacy theory and institutional theory.

Body

Stakeholder - ethical

Stakeholder theory has both an ethical (normative) branch, as well as a managerial

(positive) branch (Deegan, 2000). The ethical branch aims to meet the information needs of

a wide range of groups despite power e.g. local community, minority groups, customers,

environmental groups and individual activists etc. Under this normative perspective,

Stakeholder theory argues that all stakeholders have the right to be treated fairly by an

organization, and that issues of stakeholder power are not directly relevant. All

shareholders have a right to be provided with information because it prescribes how

stakeholders should be treated; it is a normative approach and is based on various ethical

perspectives. Managerial branch seeks to explain and predict how an organization will react

to demands of various stakeholders. Relative power and importance can change across

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time, associated with control of resources. The firm will take actions to manage its

relationships with stakeholders (Jarrett,1971).

The BP oil spill in the Gulf of Mexico under the stakeholder theory is used to evaluate the

performance of BP. It prescribes how stakeholders should be treated based on various

ethical perspectives, following the oil spill accident. BP has contacted government officials,

NGOs and investors and has listened to them expressed their concerns with BP in 2010. This

provides an example as to how the actions of stakeholder and BP under the ethical branch

of stakeholder theory aims to meet organization’s long term sustainable development of BP

in a way that will benefit various other stakeholders and not solely aim to save the public

image of BP, but also for the continuing development of their financial sustainability.

Stakeholder- managerial

The managerial branch of stakeholder theory attempt to explain when corporate

management will be likely to attend to the expectations of particular (powerful)

stakeholders. The main objective of this branch is to meet the information needs of

powerful groups e.g. government, banks, professional bodies and employees etc. Within the

managerial branch of stakeholder theory the organisation is considered to be part of the

wider social system, but this branch of stakeholder theory specifically considers the

different stakeholder groups within society and how they should best be managed if the

entity is to survive (Deegan & Blomquist 2006).

This branch considers that the expectations of the various stakeholder groups will impact

the operating and disclosure policies of an entity. The entity will not respond to all

stakeholders equally but rather, will respond to those that are deemed to be ‘powerful’

where the most powerful stakeholders will be attended to first. (Deegan & Blomquist

2006). Within the managerial perspective information is a major element that can be

employed by the organization to manage or manipulate the stakeholder in order to gain

their support and approval, or to distract their opposition and disapproval, which is

consistent with the strategies suggested by Lindblom (1994).

The managerial branch of stakeholder theory can be used as an example to provide possible

predictions about the impact the World Wide Fund for Nature (WWF) could have on the

environmental reporting practices of the Australian minerals industry. If it is accepted that

WWF is a ‘powerful’ stakeholder then the Minerals Council of Australia (MCA) and the

individual mining companies may feel a need to react to WWF’s expectations. As an

organisation with large membership and expertise in lobbying government, the WWF could

be considered to be a ‘powerful’ stakeholder group with the ability and resources to

influence the operations of mining companies.

Legitimacy theory

Legitimacy theory posits that organisations continually seek to ensure that they operate

within the bounds and norms of their respective societies, in an attempt to ensure that their

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activities are perceived by outside parties as being ‘legitimate’. Legitimacy theory relies

upon the notion that there is a ‘social contract’ between the organisations in question, and

the society in which it operates (Deegan & Blomquist 2006). These bounds and norms are

not considered to be fixed, but rather, change over time, thereby requiring the organization

to be responsive to the environment in which they operate.

It is assumed that society allows the organisations to continue operations to the extent that

it generally meets their expectation. Legitimacy emphasises that the organization must

appear to consider the rights of the public at large, not merely those of its investors. Failure

to comply with societal expectations may lead to sanctions being imposed by society. For

example, in the forms of legal restrictions imposed on its operation, and reduced demand

for its products.

Under the social contract between society and an organisation the BP Mexico bay oil spill

accident can be used as an example once again to demonstrate that BP has breached the

“social contract” with society by failing to ensure the safety and health of the society and

environment at large and has threatened the legitimacy of BP. Therefore, BP’s efforts to be

consistent with legitimacy is shown through it interactions with the relevant legal and US

government department agencies and by establishing the $20 billion Deepwater Horizon Oil

Spill Trust fund, which was created by BP to settle legal obligations stemming from the

catastrophe.

Another example is that of the mining industry’s reaction to WWF’s initiative of

independently produced a Mining Company Environmental Report Scorecard, in which it

evaluated the environmental reports of eleven Australian minerals companies was an act of

legitimation. That is, the minerals industry is attempting to communicate to the WWF, as

well as any other ‘relevant publics’, that it is changing its environmental activities in

response to the concerns of the WWF. In this way, it could be argued that the industry is

attempting to legitimate its activities by seeking to educate and inform the relevant publics

about actual changes in industry behaviour, which is consistent with Lindblom's (1994) first

method of legitimation as the corporations may view the Scorecard as a threat to the

legitimacy of their operation, and are thus attempting to legitimise their activities in

response to the WWF’s concerns.

Institutional theory

Institutional theory considers the processes by which structures, including schemas; rules,

norms, and routines, become established as authoritative guidelines for social behaviour. “It

inquires into how these elements are created, diffused, adopted, and adapted over space

and time; and how they fall into decline and disuse” (Scott 2004). This theory emphasises

that although the entity can make their own decisions, they may feel it is a norm to take

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account for social and environmental impacts as it perceived as legitimate behaviour

derived from cultural values, industry tradition, entity value etc. There are three

mechanisms underlying institutional theory, which are coercive, mimetic and normative.

Using the BP oil spill accident as an example, BP was placed in a coercive situation due to

strong concerns of society and through various stakeholders to implement business

practices in saving the reputation of BP and be consistent in social value. Following the

accident, BP’s 2012 Sustainability report is a response from coercion by various stakeholders

to demonstrate the use of safety principles to manage the integrity of hazardous operating

systems and processes to prevent accidents and oil spills in the future.

The 2010 annual report of BP, due to the society strong concern, when BP face the pressure

from the outside organization, it is the situation in coercive. BP wants to do more practices

in saving the reputation and be consistent in social value. In BP’s continue develop strategy,

deep-water resource use is an important part for future, even happened Gulf Mexico

accident.

Conclusion

Since society, politics and economies are inseparable, and economic issues cannot

meaningly be investigated in the absence of considerations about the political, social and

institutional framework in which the economic activity takes place systems oriented

theories help understand the behaviour and reporting of management, specifically when it

comes to sustainability reporting. Gurthrie and Parket (1990) states that corporate reports

cannot be considered as neutral, unbiased documents, but rather are ‘a product of

interchange between the corporation and its environment and attempt to mediate and

accommodate a variety of sectional interests.’